Fed May Have No Choice But to Step Up Rate Hikes

The decline in unemployment argues for faster action, the shortfall of rising prices argues for the opposite.

It's a tug-of-war.

Photographer: Iroz Gaizka/AFP/Getty Image

The U.S. unemployment rate fell to 4.1 percent in October, a new cycle low. Moreover, the declines won’t stop soon, and sub-4 percent rates are on the horizon. The Federal Reserve will quickly become very uncomfortable with numbers of this kind. For the time being, slow inflation still restrains the central bank to a gradual pace of interest-rate hikes. But if the inflation landscape changes, policy makers will start thinking about a more aggressive policy stance.

Joblessness is below the 4.4 percent cycle low of the previous expansion, though not as low of 3.8 percent of the 1990s expansion. Hitting that level seems possible within the next few months. The current pace of jobs expansion exceeds the growth of the labor force, which will translate into lower unemployment rates. And jobs growth does not appear likely to slow in the near future. Initial unemployment claims and temporary help employment, both good leading indicators, signal a bright future for jobs.

The Fed’s most recent Summary of Economic projections revealed an unemployment forecast of 4.3 percent for year-end, and 4.1 percent for the end of 2018. Those forecasts proved to be pessimistic, as has been the case for many years now. Rapidly falling unemployment continues to surprise the Fed.

Still, inflation surprises as well. While the unexpected decline of unemployment argues for faster rate hikes, the shortfall of inflation relative to target argues for the opposite. The Fed to date has used these conflicting signals to justify maintaining a gradual pace of rate hikes. Policy makers have a strong preference for this policy. They fear that a more rapid pace of rate hikes will only lead to recession.

But will they have much choice but to hike rates at a faster pace? Until now, low unemployment justified rate hikes, while low inflation kept the Fed’s attention off of the fact that unemployment was sinking well below their estimates of NAIRU, or the non-accelerating inflation rate of unemployment.

As unemployment moves below 4 percent and toward 3.5 percent, however, the mood at the Fed will darken. That’s uncharted territory, at least since the beginning of the Great Moderation in the mid-1980s. Those levels haven't been reached since the late 1960s.

That didn’t end well.

The problem now facing the Fed is that if you look back on the last few cycles in which the end stage was one of low inflation and low unemployment, you might conclude that the Phillips curve is dead. You might further conclude that the relationship between unemployment and inflation is so weak that the Fed should resist raising rates in response to lower unemployment. The central bank should instead keep its eye on low inflation.

If you go back further to the last time the unemployment rate sank below 3.8 percent, however, you might become a bit less cavalier about the inflation risks. If the late-1960s has any lesson to tell, it’s that the bet against the Phillips curve becomes riskier as unemployment sinks below 4 percent. I suspect that’s the way the Fed will see it.

So what does it mean? As long as the Fed’s forecast for 4.1 percent unemployment at the end of 2018 seemed intact, market participants could look to the inflation numbers and ponder the possibility that the central bank would lower the rate projections for 2018. But with unemployment looking to push below 4 percent, the opposite becomes true. Policy makers will intensify their commitment to the current rate projections and soon consider a higher path of rates to push down job growth and stabilize unemployment to stave off inflationary pressures.

And if inflation does perk up, watch out. The Fed would then need to balance the degree of tightening necessary to deal with the inflation rebound against the lagged impact of the tightening since the bank started hiking rates. This is exactly the kind of environment where monetary mistakes are made.


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